The SEC has been watching wrap fee programs for quite a while. From 2017-19, the SEC’s annual examination priorities named wrap fee programs as putting investors at risk.
The SEC’s Division of Examinations (Division) released a July 21, 2021 Risk Alert with guidance from examiners during its Wrap Fee Initiative. The Risk Alert, “Observations from Examinations of Investment Advisers Managing Client Accounts That Participate In Wrap Fee Programs,” contains compliance guidance for Registered Investment Advisers (RIAs) that recommend wrap fee programs to their clients. RIAs can benefit by reviewing common wrap fee program deficiencies, as well as the best practices observed by examiners, and using the guidance to improve your firm’s policies and procedures.
Focus of the SEC’s Wrap Fee Initiative
The Division’s Wrap Fee Initiative concentrated on:
- Consistency with fiduciary obligations
- The adequacy of disclosures provided by the advisers
- The effectiveness of the adviser’s compliance programs
To fulfill their fiduciary duty, advisers must have a reasonable basis for believing that the wrap fee programs selected are in the best interest of participating clients, initially and throughout the relationship. RIAs must document their decision-making process.
Examiners looked at whether advisers provided full and fair disclosures of all material facts to their clients. Some of the advisers did not sufficiently disclose the transaction costs owed by clients, which were not included in the bundled fee for investment advice and transaction costs.
In addition, examiners evaluated the compliance policies and procedures of the advisers examined. Policies and procedures should be designed to ensure that a wrap fee program is in the best interest of the client.
Examiners’ observations from the Wrap Fee Initiative examinations
Consistency with fiduciary obligations
Examiners found that some advisers did not adhere to their fiduciary duty and their recommendations were not made in clients’ best interest. Certain advisers did not monitor the trading activity in their clients’ accounts. Some of the advisers that did monitor the trading in their clients’ accounts failed to monitor for “trading-away” by the broker-dealers that were designated to execute trades. Therefore, clients who participated in wrap fee programs paid more than the so-called “all-inclusive fee” for asset management and trade execution.
Examiners observed that advisers did not have a reasonable basis for believing that wrap fee programs were in their clients’ best interest. Certain advisers habitually recommended wrap fee programs to their clients without full consideration of whether these recommendations were in their best interest. Some advisers conducted initial reviews but failed to consider whether the programs continued to be in clients’ best interest. A number of advisers conducted inadequate ongoing reviews, which relied upon a very small sample of accounts or systematically excluded some of them.
Adequacy of disclosures
Many of the examined advisers provided inadequate disclosures or omitted them. Disclosures were lacking regarding conflicts of interest, fees, and expenses. Examiners also found inconsistencies between advisory contracts and the wrap fee program brochure. As an example, advisory contracts stated that clients would pay brokerage fees. Wrap fee program brochures contradicted that assertion and claimed that clients would not pay those fees. Examiners did not review Form CRS, because the examinations occurred before the June 30, 2020 compliance date.
Advisers frequently omitted or inadequately described the financial incentives the examined advisers and their supervised persons received. Examiners discovered that supervised persons engaged in transactions that reduced costs to the adviser but increased expenses borne by the client. In some instances, supervised persons avoided ticket charges by recommending that clients purchase mutual fund share classes charging 12b-1 fees, which were likely to be more expensive for them.
RIAs did not always disclose that a client with low trading volumes, high cash balances, or significant fixed income holdings might pay more by switching to a wrap fee program. They also did not disclose that certain transactions were excluded from the bundled fee, which caused clients to pay higher costs.
Effectiveness of RIAs’ compliance programs
A large number of the examined advisers had weak or ineffective policies and procedures for compliance. Worse yet, advisers sometimes ignored their own policies and procedures. Some did not conduct an annual review of their policies and procedures. Annual reviews give RIAs the opportunity to improve and strengthen their policies and procedures.
Certain RIAs omitted key compliance policies and procedures, such as initial and ongoing best interest reviews. Some of the examined advisers followed internal guidelines or informal practices for key operational areas. They did not, however, memorialize and implement those practices in their written compliance policies and procedures. Examiners identified areas where RIAs relied on informal practices including:
- Conducting best interest reviews of clients’ accounts
- Conducting best execution analysis of wrap fee accounts
- Selecting separate portfolio managers to advise portions of clients’ wrap fee accounts
It is not enough for RIAs to draft robust policies and procedures. They must be fully implemented and enforced. Several of the examined advisers did not:
- Conduct due diligence on third-party portfolio managers they recommended to clients, even though the RIA states it conducts due diligence
- Review clients’ accounts and billing of fees in accordance with their policies and procedures
- Implement policies and procedures governing best interest reviews, advertising, codes of ethics, and the quality of disclosure documents
Best practices derived from the Division’s Risk Alert
Although the Risk Alert did not endorse any specific approach, it did offer best practices for advisers associated with wrap fee programs. Advisers must conduct initial and periodic reviews of wrap fee programs to make sure their recommendations are in the best interest of clients. RIAs must have documentation to demonstrate that they evaluated clients’ financial situations, investment objectives, and risk temperament. They must also determine the appropriateness of the account type selected, as well as the portfolio selections and asset allocation recommendations.
The Risk Alert encourages RIAs to remind clients periodically to notify the adviser if their financial needs, investment goals or personal situations change. Before recommending to clients that they make a change to a wrap fee program, advisers should educate them about the differences between the accounts.
In the area of disclosures, the Risk Alert stressed the importance of disclosing that the adviser receives compensation or incentives from wrap fee program sponsors or portfolio managers. RIAs must also disclose that the adviser has a financial incentive not to migrate infrequently traded wrap fee accounts to brokerage or non-wrap fee advisory accounts. Policies and procedures should spell out what constitutes an infrequently traded account.
In addition, advisers must provide clear disclosures regarding whether certain services or expenses are not included in the wrap fee, such as certain types of trades. They must disclose that additional expenses may be incurred by clients, such as transfer taxes and electronic fund transfer fees.
With regard to compliance programs, the Risk Alert emphasized the importance of monitoring and validating that the adviser sought best execution for clients’ transactions. Best execution reviews must take place periodically, and the results should be documented. Policies and procedures should ensure that advisers have knowledge or control over the trading executed by the underlying portfolio managers in the wrap fee programs, including trading-away activity.
Wrap fee programs are not in the best interest of every client. Using information obtained directly from clients, advisers should conduct initial and periodic reviews of wrap fee programs to make absolutely certain they are in clients’ best interest. Examiners are going to be skeptical if an adviser recommends a wrap fee program to every client onboarded to the firm.
Informal practices regarding wrap fee program recommendations are not meaningful. Examiners expect RIAs to implement and enforce compliance policies and procedures applicable to wrap fee programs.
Risk alerts should be used by RIAs to improve their compliance policies and procedures. RIAs should not wait for their annual review of their policies and procedures to enhance them. An examination might occur before those improvements are made.
The Division’s Risk Alert can be found HERE.
A SmartRIA Solution
Automated alerts for low trading volumes and high cash balances are available through our SmartRIA compliance software, as well as documentation of annual reviews and other alerts. Advisors can file annual reviews and client communications through SmartRIA software, making oversight of accounts and clients easier to manage for compliance teams. This makes sure that fiduciary duty is transparent & documented, and regulatory obligations are fulfilled. As stated above, it is not enough for RIAs to draft robust policies and procedures. They must be fully implemented and enforced. Learn more about SmartRIA and request a demo here.